I am long in Apple (NASDAQ:AAPL), like so many of you out there, because it’s a simple way to beat the market. Take a diversified portfolio and overweight yourself in Apple — well … even more overweight than the Nasdaq and its 13% in AAPL or the S&P 500′s 5%, that is — and it’s an easy way to go over the top.
Except, what happens when that shiny Apple sours?
To prevent the fallout, you might want to buy some insurance in the form of put options.
I’m not saying I don’t believe in Apple — I personally am long, as I said. But the stock looms large for everyone. Apple isn’t just an iconic stock — it’s a market mover. Hell, a JPMorgan Chase (NYSE:JPM) analyst predicted the iPhone 5 could add 0.25 to 0.5 percentage points to GDP all by itself! That kind of power is great on the way up, but can be troublesome on the way down.
Circumstances have caused some folks have decided to sell a partial stake and take profits off the table in Apple … But the massive profit potential makes many investors — myself included — reluctant to sell even a single share early. After all, the iPhone 5 just came out and could have big potential.
That leads us to a great alternative if you have a brokerage account that allows you to trade options: a so-called “protective put” on your Apple shares. This strategy involves picking a floor for the stock where your downside protection prevents further losses.
Let’s say you bought Apple at $550 on a dip this spring, and want to at least break even. You then buy a put option that gives you the right (but not the obligation) to sell your Apple stock at $550 no matter what for the period of the contract. Even if Apple trades lower than that, you are guaranteed this floor, though you are out the cost of the option.
Sounds good, right?
It’s a great strategy — not just for Apple, but for any stock where you’re worried about the downside risk, yet don’t feel comfortable exiting the position just yet.
It’s not perfect, though. Here are the catches:
Options contracts are sold in lots of 100: For most stocks, options contracts are sold in a lot of 100 — but clearly that’s cost-prohibitive to Apple investors. If you have only three or four shares of AAPL stock, protective put options aren’t a good option here. Sorry.
It’s not free: There is a cost, naturally, for buying a put. That cost varies based on demand for a given price and the time frame of the contract. For instance, buying a contract to sell 100 shares of Apple at $550 with an October 20 expiration would cost you a mere $72 as of today — super-cheap, since it’s very unlikely in the mind of many investors that Apple will be trading that low. However, January 2014 puts at $550 cost $4,955 as of this writing for a 100-share contract. That’s a much higher price point because there’s no telling what Apple could be trading at — it could be $400 or even less if all heck breaks loose. So you pay a higher premium for insurance that’s so long-term.
If the stock soars, you still pay: Like insurance for your car, you don’t get a refund if you drive for 10 years without an accident. You still have to pay — even if you never have to use your coverage. Same thing with these options contracts. Sometimes you can sell your put contract to someone else instead of selling your actual stock, thus recouping some of your losses, but if the stock goes significantly higher, you’re going to just watch your “insurance” expire. And you’ll be out whatever money you paid for the contract.
Protection only lasts as long as the contract: If you have a put contract through January but Apple tanks in November, you’re fine — you can even hang on all the way to expiration of your contract in January to see if Apple winds up rebounding. But if Apple falls off a cliff in February … well, you better have a new contract or you’re not covered. Worst of all could be if Apple sharply declines on the last day of your contract and you have to decide whether to exercise your puts or hang on and hope for a rebound. If you decide to bail out but Apple comes back, you might wind up kicking yourself for being rushed into a sale just because of the options contract.
As you can see, there are some wrinkles to work out. But the bottom line is that a protective put is akin to insurance — it’s there if you need it, and doesn’t obligate you to use it if things stay positive for Apple.
The only thing you’ll be out is the cost of a contract. And if that cost gives you peace of mind, it’s money well spent.
Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, he held a long position in Apple.